With actively-managed large-cap funds finding it difficult to beat the benchmark over the past few years, interest in passive investing is rising. The assets of index funds and exchange-traded funds (ETFs), the two alternatives for passive investing, account for close to 20% of the assets of total equity mutual funds as of October 2019 compared to less than 1% five years ago in November 2013, according to data from Value Research and Association of Mutual Funds in India (Amfi). Currently, there are 89 equity index funds and ETFs tracking the indices of both the National Stock Exchange (NSE) and BSE Ltd compared to around 40 in November 2013.
Passive funds replicate the index they track. They have the lowest expense ratio and are considered less risky than active funds. But there are some factors that can impact passive fund’s performance, especially in an emerging market such as India, where the equity markets are not as mature as developed markets such as the US or Japan. Here are three such factors.
Both NSE Nifty and S&P BSE Sensex, two broad market indices, are market-cap weighted indices. In other words, in these indices, a stock (trading currently) with a higher market-cap has a proportionate higher weightage. For a fund replicating the index, this results in higher concentration of a few stocks. In a market where only a few stocks drive the rally, the concentration increases. For example, the weightage of the top five stocks in the Nifty is up from 39% in November 2018 to 42% in November 2019, according to data from Motilal Oswal Institutional Equities and NSE. Similarly, there is sector-level concentration. For instance, the financial services sector accounts for 41% of the Nifty and 46% of the Sensex.
“A high concentration in sectors or at the security level is considered risky. A more diversified portfolio reduces the impact of poor performance from a given sector or issuer,” said Harish Toshniwal, product manager, Morningstar Indexes.
While a concentrated portfolio has the risk of going down along with the stocks or sectors it is overweight on, it can also reward well when these stocks or sectors are doing well. “If I look at the large-cap index, a large part of the return can be attributed to the performance of a few stocks. This automatically creates concentration. Since a few number of stocks have delivered returns, it is possible that when these stocks underperform, the index will also take a significant hit. Therefore, the passive fund tracking the index will also get hit,” said Shyam Sunder, managing director, PeakAlpha Investment Services, a financial planning firm. “In the case of an actively-managed fund, a manager will ideally avoid taking concentrated bets or at least have the leeway, which is not there in passive funds,” he added.
Higher tracking error
Tracking error is the difference between the returns of an index and the fund tracking it. According to data provided by Value Research, the tracking error of various ETFs and index funds is in the range of 0.02% to 3.55% over a three-year period as on 30 November 2019.
A higher tracking error shows that the fund is not replicating the index truly due to higher cash or expense levels or different allocation to stocks. This exposes it to the risk of deviating from its mandate.
Tracking error in Indian passive funds is higher as compared to global passive funds and there are multiple reasons behind this. “Factors such as the fees and expenses of the scheme, cash flow due to large subscriptions and redemptions, brokerage costs plus securities transaction tax, corporate actions like dividend distribution, halt in trading on the stock exchange due to circuit filter rules, lack of liquidity, cash balance and changes to the underlying index result in tracking errors for passive funds,” said Pratik Oswal, head of passive funds business, Motilal Oswal Asset Management Co. Ltd.
ETFs that manage to keep lower expense ratios and limit the costs have lower tracking errors. “It is in the range of 1-2 to 30 basis points for well-managed ETFs in India, especially the liquid ones that track indices like Nifty and Nifty Next 50,” said Vishal Dhawan, founder, Plan Ahead Wealth Advisors.
Liquidity can be an issue in case of ETFs as they can only be bought and sold on the exchanges, unlike index funds. You would be able to sell only if there is enough demand and that may not always be the case. “Liquidity is an issue for ETFs other than ETFs tracking Nifty and Nifty Next 50 and banking indices,” said Dhawan.
Also, the ETFs may be trading at a discount to the net asset values (NAVs) or at a premium, depending on the demand for the ETF on the exchange.
What you should do
One of the ways in which you can mitigate concentration risk is investing in passive funds that track equal-weighted indices, in which the weight of every stock is the same. There are index funds such as DSP Equal Nifty 50 Fund, Principal Nifty 100 Equal Weight and Sundaram Smart NIFTY 100 Equal Weight Fund, which track indices that allocate equally to all stocks in the index. “This can be an alternative but there aren’t many options available right now,” said Sunder.
You can also go for a combination of active and passive strategy, according to experts. “Given the fact that how passive funds have performed in the large-cap space, especially in the last few years, it would make sense for investors to allocate around 50% of the large-cap allocation to ETFs or index funds. While in other buckets, such as small- and mid-cap and sectoral funds, it would be better to go with active funds as they have been able to generate higher alpha,” said Dhawan.
How you divide your portfolio between active and passive funds also depends on your risk appetite and return expectation. Consult a financial planner if you are unable to decide on your own.